In the initial contract negotiation stage, the contract price with SM was $10.1

Question

In the initial contract negotiation stage, the contract price with SM was $10.1 million in cash. However, as part of the final contract negotiations, SM agreed to give EYE SPY its old surveillance equipment in exchange for a credit of $100,000. It is expected that this old surveillance equipment will not be decommissioned until the new equipment is operational. Based on its extensive experience, EYE SPY’s management believes it is probable that the estimated fair value of the old equipment at the contract inception date is $115,000. There was also a provision in the contract that SM would receive a discount (similar to that which, would be reflected in a separate financing transaction between EYE SPY and SM) from the contract price of $10 million if they paid within three days of when the contract was signed. EYE SPY determined a discount of $500,000 for this financing based on applying the typical credit rate for the equipment and integration services to be delivered at the end of year one and the monthly delivery of maintenance services in year two through six of the contract. SM wired $9.5 million to EYE SPY two days after the contract was signed. In the interest of full and expanded disclosure, EYE SPY has decided not to apply the practical expedient in ASC 606-10- 32-18. Due to deep security concerns and recent losses of proprietary information, SM also offered a bonus to EYE SPY if the integration was completed early and EYE SPY agreed to pay a penalty if the integration was completed late. EYE SPY has a large number of contracts with bonus characteristics similar to the contract with SM. The following is the schedule of the potential bonus or penalty. While no specific outcome is probable, EYE SPY’s management assessment of the likelihood of completing the integration in the specified time frame is based on significant historical experience with similar integration jobs.

Completed Bonus Penalty Percentage 10 months $100,000 17%

11 months 50,000 27%

12 months 0 $ 0 46%

13 months (50,000) 7%

14 months (100,000) 3%

15 months plus (500,000) 0%

Total 100%

Requirement:

2.1 Perform step three of the revenue recognition model and determine the transaction price. By reference to the applicable accounting literature, provide a detailed analysis to support your conclusion.

2.2 Record any required journal entries for the first two days of the contract.

Explanation / Answer

2.1)

This new standard on revenue recognition is a principles-based approach (with some guidance) rather than a “bright line” rules-based approach. It will be a single revenue recognition model applied across all industries and transactions. When the new standard becomes effective, industry-specific revenue recognition accounting will no longer exist. This is a significant change.

The core principle is that “an entity must recognize revenue when it transfers promised goods and services to the customer and the amount recognized should be the consideration to which the entity expects to be entitled.” Businesses will determine the correct revenue recognition using this Five Step Model:

1. Identify the contract(s)
2. Identify the separate performance obligations
3. Determine the transaction price
4. Allocate the transaction price to the separate performance obligations
5. Recognize revenue when the entity satisfies a performance obligation

The Five Step Model appears manageable, but let’s look more closely at each step.

Step 1: Identify the contract

A fairly straightforward step whereby specific criteria must be met in order to have a contract. Specifically, the contract must have commercial substance, the promised goods and services must be identified and approved, and the payment terms identified.

Step 2: Identify separate performance obligations

This is applicable when an entity transfers more than one good or service to the customer and the additional good or service is distinct. In order for a good and service to be distinct it could be sold separately or the customer can benefit from the good or service either on its own or together with readily available resources. However a good or service is not distinct if it’s bundled with other goods and services; if the business services are highly interrelated; and if the goods and services are significantly modified or customized. As an example, if you sold a car with a 5-year warranty included in the purchase price and sold a separate three-year extended warranty. The three-year extended warranty would be a separate performance obligation.

Step 3: Determine the transaction price

According to the new revenue recognition model, the transaction price “is the amount of consideration to which the entity expects to receive for the transfer of the promised goods and services.” In determining the transaction price, management will need to take into consideration the variable consideration, time, value of money, non-cash consideration, and consideration payable to the customer.

The determination of variable consideration will require significant amount of judgment. Variable consideration includes items such as discounts, rebates, refunds, and royalties. In estimating the transaction price the entity would use either the expected value method or the most likely amount method. I will state the obvious here, but both of these methods require management’s best guess. In addition, for an entity to estimate the variable consideration the entity must have relevant experience with the item and the probability of significant reversals would not occur.

Step 4: Allocate the transaction price to the separate performance obligations

A business determines this based upon the relative standalone-selling price of each performance obligations. In determining the standalone-selling price, management needs to identify observable evidence. If none exist management will need to use a method of estimation to determine the standalone-selling price. Once this has been determined they allocate the amount of consideration expected to each of the separate performance obligations.

Step 5: Recognize revenue when the entity satisfies a performance obligation

This is accomplished when the customer obtains control of the good or service. If the performance obligation is satisfied over time (construction of an asset), and there exists continuous improvement of the asset, the entity would use a progress method (output or input method) to recognize revenue. The percent of completion method would not be used during the step.

The new model requires that management make more estimates and judgments in areas of identifying separate performance obligations, determining the transaction price, variable consideration, the allocation of the transaction price, and when control has been transferred. This increase in estimates and judgments mean that management should assess and update internal controls and processes to avoid fraud.

2.2 Record any required journal entries for the first two days of the contract.

Answer- very soon

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